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Online Extra: Frank Raines Takes on the Critics (extended)

June 29, 2003

When mortgage financier Freddie Mac dismissed three top managers on June 9 amid questions about the company's accounting practices, the fallout hit Fannie Mae, Freddie's larger cousin. Both Fannie (FNM) and Freddie (FRE) are government-sponsored enterprises (GSEs), meaning they're publicly traded companies but with federal charters that give them some quasi-government features. For example, they're exempt from some state and local taxes, they have a line of credit from the federal government (it has never been tapped, however), and they aren't required to register their debt or equity with the Securities & Exchange Commission. Both companies use derivatives -- complicated financial instruments -- to manage risk in their huge portfolios.

However, that's where the parallels end, insists Fannie Mae Chairman and CEO Franklin D. Raines. To respond to critics, Fannie voluntarily has registered its equity (not debt) with the SEC. Freddie says it will but hasn't carried through yet.

In his first on-the-record interview on how Freddie's scandal is affecting his company, Raines spoke on June 17 to BusinessWeek Senior Writer Paula Dwyer. Edited excerpts of their conversation follow. Note: This is an extended, online-only version of the interview that appears in the June 30, 2003 issue of BusinessWeek.

Q: Freddie Mac's troubles unnerved the markets and raised anew the question: Are you taking on too much risk?

A: The interesting fact from the Freddie situation so far is how little market impact it has had. I think that shows that markets are a lot more resilient and a lot smarter about responding to unexpected events than we think.

Q: But investors are saying, "If it happened at Freddie, it could happen at Fannie." What if investors are no longer willing to lend to you at below-market rates?

A: That's the same question you'd ask if General Motors (GM) had a decline in their credit rating. We can absorb tremendous blows that other companies could not. We hold 30% [excess] capital in event of management mistakes. The market knows that events of the magnitude that Freddie Mac absorbed are not going to cause a safety and soundness problem.

Q: Because of similarities between Fannie and Freddie, you are tarred by the same brush. Is this fair?

A: As President Kennedy said, life is unfair, so we just have to get used to that. I don't know that much about how Freddie operates. But when it came to accounting for our derivatives, we spent millions of dollars on internal systems [and] we maintain strict control over what kind of derivatives can be used and our accounting for them. Everyone who has looked at it, from our external auditors to our regulators, found that we are doing this in a state-of-the-art way. We are compulsive about managing risk.

Q: What happened at Freddie has given your adversaries a lot of ammo. Is the risk that Congress will take away some of your special advantages?

A: Our adversaries have not normally needed an excuse to attack us. What Fannie Mae does is important to the country and to home buyers. And we do it, I think, very well. And as long as those two things are true, I don't expect Congress will take any action.

A: I guess for the same reason we don't break Citigroup (C) into pieces. Citigroup is bigger than we are. We have a long history in this country of concern about big financial institutions. What we found, particularly in the housing market, is that having large institutions is vital. We are able to manage and disburse risk in ways that smaller institutions cannot.

Q: So you're saying bigger is better?

A: Bigger has worked in the mortgage market. We've got over $6 trillion in mortgage debt outstanding now. That's bigger than the market for commercial loans, corporate bonds, and credit cards combined. So yes, we are big, but the market is still enormously bigger than we are. Around the world, there has been a trend toward large institutions because they are more efficient.

Q: House Capital Markets Subcommittee Chairman Richard H. Baker's (R-La.) call for tighter regulation of government-sponsored enterprises, like Freddie and Fannie, is gaining momentum. So are measures to require you to register your debt with the Securities & Exchange Commission. What's your view of these proposals?

A: Freddie Mac's problems do not relate to the fact that they are a GSE. Other companies have had similar accounting difficulties, and they weren't GSEs.

What we don't want is to have things imposed on us that are going to make the housing system worse, such as registration. Registering 1,500 debt issues and 40,000 mortgage-backed securities (MBS) issuances with the SEC is a bad idea for housing. It would just stop the system. The SEC has never dealt with that number of issues.

Q: But the regulator responsible for keeping tabs on Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight, is widely seen as weak. It certainly didn't catch Freddie's problems. Doesn't that justify stronger regulation?

A: It depends on whether you think that's unique. Major banks have had to restate their financials, and this wasn't "caught" by their regulators ahead of time. Banking regulators are in the business of ensuring safety and soundness. Auditors are in the business of ensuring proper accounting. You can't assume they're going to be able to ensure that no company is going to make mistakes. Management mistakes happen.

It's the board's responsibility to ensure that you've got strong management and to hold management accountable. This is more of a governance and management-control question than a regulatory question.

Q: So Freddie is an example of failed corporate governance?

A: We have to find out the facts. The board decided that management was not performing and replaced it. Some people say they didn't do it fast enough, some people say they did it too fast. When the facts come out, we'll know more what motivated them.

Both companies agreed to register with the SEC, but Fannie Mae got it done and they didn't. The market is recognizing that there are differences in performance, just as there are differences between Coke and Pepsi. And there is nothing that regulators can do to make those differences go away.

Q: What are you doing to reassure Congress, your critics, and the investing public that you have nothing to hide and that the risk you pose to the overall economy isn't too high?

A: There are many things we can do that don't require laws. That's why they should be judicious about passing new laws. Last week we put out six new factors [explaining common features found in each] of our outstanding mortgage-backed securities. We did that voluntarily. We have [made] state-of-the-art disclosures, as a result of our ongoing campaign for transparency.

We are aware that people have questions about companies today, particularly on issues that are complex, and we think they have a right to an answer. When the [Freddie Mac] issue came up, we immediately put up [on our Web site] how we go about accounting for derivatives. Nothing requires us to do that. Our disclosures today go beyond other SEC registrants' we're aware of.

Q: Couldn't Congress and the SEC devise an expedited system similar to the shelf registrations that large companies now use for their securities?

A: If you do a shelf registration that has no requirements, then why are we doing it? Let me give you another example of why it's a bad idea: Right now, if you go to sign up for a mortgage, they'll tell you they can't close for 60 days because they're so busy. If you say: "Look, I want today's rate." They'll say: "Fine, we'll lock you in at today's rate."

How do they do that? Lenders sell a mortgage-backed security [MBS] at today's rate, to be delivered in 60 days, and it will contain your loan and other loans that originated today. That's called the "to be announced" market, the TBA market. That allows every lender big and small to hedge, which is very valuable to consumers. But a TBA market is illegal under a registration scheme. Under the securities laws, you have to register first, and then sell.

People who are proposing [registration] aren't interested in disclosure. There's no gain whatsoever from registration. Even the people who currently register probably shouldn't have to register mortgage-backed securities. The reason they want [Fannie Mae] to do that is they want to raise our costs. That's why we call the folks who are supporting this the coalition for higher mortgage costs.

Q: Don't they just want the ability to compete with you?

A: We only own 11% of the mortgages. We have a larger percent of fixed-rate mortgages -- like 20%. So we have enormous competition. The biggest holders of mortgages are banks. And in fact they've been the fastest-growing holders in the last three years.

But the way they want to compete with us is to raise our costs, not to cut theirs. You'd think the argument would be "let us not register our [MBSs]." That's leveling the playing field. What they want is to raise our costs, and that just raises costs for everybody in the system. We have a lot of advantages, but we also have a lot of requirements on us that others don't have, and no one talks about that.

A: I think Chairman Baker is very clear. He has said it to me, and he has said it publicly that his goal is make sure that the next S&amp;amp;amp;amp;L crisis does not happen on his watch. He has held 12 hearings [since 2000] on Fannie Mae and Freddie Mac, which is entirely appropriate.

He and I would only differ as to where the danger [to the financial system] might come from. We have a whole other group of entities, whether it's the home-loan banks or other unregulated financial institutions that deserve a look as well. Enron was essentially an unregulated financial institution because of what it was doing in energy and broadband trading, and it blew up. We have a lot of very large financial institutions that aren't regulated at all.

I agree with him that it's appropriate to examine Fannie Mae and Freddie Mac. But I also believe there are other entities that deserve examination as well, and I encourage him to expand his scope. EDITED BY Edited by Patricia O'Connell